More on CSR in the Companies Bill

(The following post has been contributed by Satvik Varma)

It has been reported in yesterday’s Economic Times that the Ministry of Corporate Affairs is perhaps doing away with the mandatory spend of 2% on Corporate Social Responsibility (“CSR”). While details of any such changes are not available on the Ministry’s website, based on the news report, it is most likely that the Companies Bill will now only contain a provision requiring corporations to disclose to their shareholders whether they have made a 2% contribution to CSR and, if not, their reasons for not making the said contribution. Thus, while the disclosure to corporate shareholders may be made mandatory, the actual implementation of the prescribed percentage will not.

I had written on the proposed mandatory 2% spend last week and the provision as it was previously drafted was more in the nature of a tax and took away from the whole concept of CSR. Based on what has been reported, it is extremely unclear on what gets achieved by this change (rather than doing away with the whole provision) and what also remains to be seen is whether such a benign provision can help achieve the larger objective of getting corporates to accept their responsibility to society, their stakeholders and the environment in which they operate. Such provisions only make their compliance a check-the-box obligation and can in fact deter from the larger and more desirable social objectives. If nothing else, the Ministry should look into making public the list of corporate defaulters so that the customers and other stakeholders are aware of such non-compliance and can at least impose moral pressure on corporations to comply with their CSR obligations, both which are prescribed by law and those which corporations should themselves be fulfilling.

- Satvik Varma

Scams and Corporate Governance

The various scams afflicting India over the last few months were largely perceived as matters within the realm of public governance involving the Government, ministers and officials. Lately, however, the spotlight seems to be shifting to the private sector and to companies that are alleged to be beneficiaries of public mismanagement of resources. Questions are being asked about the acts and omissions of the corporate sector.

After reading two op-eds today, one by T.N. Ninan in the Business Standard and the other by Shailesh Dobhal in the Financial Express, I cannot help but begin to wonder (at the risk of sounding sensationalistic): Is there another wave of corporate governance crises lurking beneath the surface?

Poison Pill Lives on in Corporate America

(Mihir had earlier highlighted the importance of a recent Delaware Chancery Court decision in the Airgas case.

We now have a post by Karan Singh Tyagi, who succinctly analyzes the impact of the decision under Delaware law and goes to the nub of the issue involving the role of the board of directors of a target that is the subject matter of a hostile bid.

Karan is currently an associate at Gide Loyrette Nouel, Paris. After obtaining his law degree from the Government Law College (Mumbai) in 2009, Karan went on to do his LL.M. from Harvard Law School last year.)

On February 15, 2011, the Delaware Court of Chancery delivered the much-anticipated decision in the year long takeover battle between Air Products & Chemicals, Inc. and Airgas, Inc. Corporate attorneys in the US and shareholder activists around the world were calling it one of the most important law suits in a generation, and rightly so. Almost half of all publicly traded corporations in America, and approximately two third of the companies in the Fortune 500 are registered in the state of Delaware, and the outcome in any Delaware case significantly affects entire corporate America.

In the current case, the legality of the 'poison pill' (shareholders' rights plan), invented in the early 1980s by the preeminent Martin Lipton, was in dispute. Briefly, poison pills are instruments designed to derail hostile bids. The pill works by distributing rights to all shareholders to buy the company's stock at a discounted price. These rights get triggered when a hostile bidder acquires a certain percentage of the company's outstanding stock (15% per cent in the Airgas case). The critical part, however, is that the hostile bidder whose stock acquisition triggers the discounted buying is itself excluded from buying the discounted stock. This results in a substantial dilution of the bidder's stake, which is so great that no rational bidder would want to set off the pill, and go ahead with the bid.

For nearly a year, the Airgas board of directors had relied on its poison pill, to protect itself from the Air Products' hostile offer. Air Products moved the Delaware Court of Chancery for a judicial redemption of the poison pill contending that the pill should be pulled as a matter of shareholder choice. Their argument was that under Delaware law there was no longer any threat to shareholders or the company that justified keeping the poison pill in place, since the current offer of $70 per share was at a substantial premium than the company's prevailing share value.

Despite the fact that Air Products' tender offer had been public for more than a year, during which time Air Products won a proxy contest to place three directors on Airgas's staggered board, and that Airgas stockholders were sophisticated and well-informed, the Court concluded that the Airgas board "acted in good faith and in honest belief" that the $70 per share offer was inadequate, and thus did not breach a fiduciary duty by failing to redeem the company's poison pill.

The court based its reasoning on the threat of 'substantive coercion'- a term coined in an article by Harvard Law School Professor Reinier Kraakman (co-authored with Stanford Law School Professor Ronald Gilson). 'Substantive coercion' essentially means the risk that shareholders will mistakenly accept an underpriced offer because they disbelieve management's representations of the company's intrinsic value.

Nevertheless, the court acknowledged that the poison pill had "served its legitimate purpose" in delaying the consummation of the bid by more than a year, and it had given the shareholders sufficient time to decide whether to tender their shares or not. Chancellor Chandler, who wrote the opinion for the Court, held that he was compelled by controlling Delaware precedent to uphold the poison pill, and suggested that the Delaware Supreme Court should consider modifying the current rule.

Chancellor Chandler's personal views appear to be a nudge to the Delaware Supreme Court to strike a certain balance between the board and the shareholders, which is straying too far in favor of the board under the current Delaware precedent.

Going forward, the Delaware Courts should push for the right balance between the director-centric and the shareholder choice model, especially in cases like the current one where the offer is not structurally coercive, and is all-cash, fully financed, and the stockholders have sufficient time to be completely informed about the offer and the board's business proposal. In such cases, there are strong policy reasons to give shareholders an opportunity to decide for themselves.

More importantly, it should be remembered that the poison pill was widely adopted when the business climate in America was one of 'corporate raiders'. These 'raiders' were essentially looking to buy low through 'front-end loaded and two-tier' tender offers, and looking to sell high. Undoubtedly, these offers could lead some shareholders to sell, even if they were being offered a price less than what they believed their shares were worth. Poison pills in this economic climate served the purpose of enabling the board to act as a bargaining agent for the dispersed shareholders.

However, in the current economic scenario, and especially in the context of the current case, the poison pill has gone far beyond its original purpose. The offer price was $70 for Airgas, whose shares had been trading around $63 per share. After the Court's decision, Airgas shares fell to around $60 per share. Looking through the prism of shareholder value, this appears to be a major loss for the shareholders of Airgas.

Underlying this case was a very fundamental question pertaining to the allocation of power between directors and shareholders. In the words of the Court: "in the context of a hostile tender offer, who gets to decide when and if the corporation is for sale?" In answering this question, the Court solidified the notion that power resides with the board of directors in business-friendly Delaware, and in doing so confirmed corporate America's outlier position in the world in favoring a director-centric model of corporate governance rather than a shareholder choice model. Is this the correct approach? The fact remains, that no would-be buyer has successfully navigated both a poison pill and a staggered board. Also, there is strong empirical research supporting the proposition that vulnerability to a hostile takeover has an important disciplinary effect on corporations. Corporate America can ill-afford to lose out on this disciplinary effect.

- Karan Singh Tyagi

RBI’s Draft Guidelines on CDS

Following its draft report released in August 2010, the Reserve Bank of India (RBI) has issued draft guidelines on credit default swaps (CDSs) for corporate bonds.

One of the principal objectives of this effort is to boost the corporate bond market. As RBI notes:

The objective of introducing Credit Default Swaps (CDS) on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk. CDS as a risk management product offers the participants the ability to hive off credit risk and also to assume credit risk which otherwise may not be possible. Since CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers, such products would increase investors’ interest in corporate bonds and would be beneficial to the development of the corporate bond market in India.

However, CDSs are susceptible to great risk, as the experience from the global financial crisis bears. Cautious of this factor, the RBI has imposed a number of checks and balances on the CDS market. For example, entities that are permitted to buy CDS protection may do so only to hedge against their underlying exposure to corporate bonds. They are not permitted to hold CDSs without appropriate underlying securities. The idea is to curb speculation.

There seem to be opposing concerns regarding the introduction of CDSs as well as the regime governing them. On the one hand, it is felt that the instrument is too risky to be introduced in the markets given the current environment. India’s own experience in dealing OTC derivatives has not been satisfactory, as several transactions had been mired in litigation over the last few years. On the other hand, proponents of CDS as a risk protection mechanism feel that the introduction of such an instrument with numerous restrictions will make it non-palatable to the investing community, thereby rendering it a non-starter. RBI has adopted the path involving some tight-rope walking.

The draft guidelines include some language on risk management and mis-selling:

3.1.6 Risk Management – Role of Board and Senior Management

3.1.6.1 Participants should consider carefully all related risks and rewards before entering into CDS transactions. They should not enter into such transactions unless their management has the ability to understand and manage properly the credit and other risks associated with CDS. They should establish sound risk management policies and procedures integrated into their overall risk management.

3.1.6.2 Participants which are protection buyers should periodically assess the ability of the protection sellers to make the credit event payment as and when they may fall due. The results of such assessments should be used to review the counterparty limits.

3.1.6.3 Participants should be aware of the potential legal risk arising from an unenforceable contract, e.g., due to inadequate documentation, lack of authority for a counterparty to enter into the contract (or to transfer the asset upon occurrence of a credit event), uncertain payment procedure or inability to determine market value when required. They should consult their legal experts on these and other related legal aspects before engaging in CDS transactions.

…

3.1.10 Prevention of mis-selling and market abuse

Market-makers may ensure adherence to suitability and appropriateness criteria (as stipulated in the circular RBI / 2006 – 2007 / 333 DBOD.No.BP.BC.86 / 21.04.157 / 2006-07, dated April 20, 2007) while dealing with users. From the protection buyer’s side, it would be appropriate that the senior management is involved in transactions to ensure checks and balances. In this connection, following may be ensured by the protection sellers:

a. CDS transactions shall be undertaken only on obtaining from the counterparty, a copy of a resolution passed by their Board of Directors, authorising the counterparty to transact in CDS.

b. The product terms are transparent and clearly explained to the counterparties along with risks involved. 

The above protective mechanisms seem to be a direct fall-out of the OTC derivatives litigation in India involving banks and corporates. Please see here and here for a flavor of the issues that arose in the litigation.